Why Emotions And Investing Don't Always Mix

We probably all remember the carnage of 2008, right? That may be all I need to say to convince you that diversification matters, but for the sake of etching it into our minds, I will share a story, one I have told many times to illustrate the importance of not letting emotions guide you while investing.

We should use emotions in combination with wisdom to help make good decisions.Getty Images

Back in 2007, a colleague was helping one of his clients who had recently retired from Wachovia. This client had about $1 million in Wachovia stock. My colleague explained the importance of diversification and that he was overexposed with this much in one position.

"It's Wachovia," the client said. "It's not going anywhere, and it pays a really nice dividend."

When the crisis started in 2007, Wachovia stock was priced at $51.32, and had been priced as high as $59.85 in April of 2006.1 Well, it began to drop. My colleague called his client and told him he needed to sell and diversify his assets.

"No," said the client. "I'm not going to sell when it is down. It will come back, and the dividend is important to me." Wachovia stock continued to plummet.

My colleague called him again and said, "I really think we need to get out and stabilize your account through proper diversification."

"I'm not going to sell right now,” said the client. “I’m watching it, and I want to wait for it to climb back up before I sell.”

Well, he never sold it. Wachovia went all the way down to $1.84 on September 29, 2008, causing him to lose much of the value of his stock and assets.(1) And, this was just after he retired! I can think of few things more disconcerting than realizing your retirement nest egg has just cracked.

What was his problem? He fell in love with his holdings. Stocks are an investment. They are a tool — plain and simple. You purchase them to help you grow your assets or provide income based on your needs. They do not give you love or show affection, so treat them with wisdom and not based solely on emotion. Here is the problem: It is virtually impossible to check your emotions at the door when it comes to investing. Rather than trying to do the impossible and leave emotions totally out of the picture, we should use them in combination with wisdom to help make good decisions.

Let's take a moment and think back on some of the worst decisions you have made in your life. Maybe it was dating that guy or girl. Maybe it was rebelling against your parents. Maybe it was buying that car, taking that job, or bursting out in anger at someone you care about. Think back on your bad decisions. I would be willing to bet almost all of them were emotionally based. Am I right? It's human nature. Of course, our emotions have led to a ton of great outcomes too, so it’s important to not totally disregard them. Rather, let's use our emotions to develop an investment plan that matches what we want to accomplish. If done correctly, when the market is in the middle of a scary plunge or on a positive run like we have never seen, we can have confidence rather than fear with every news article or TV segment.

"How do you accomplish this?" you might ask.

Well, herein lies the trick. You need to own different stuff! Do you know if stocks are going to outperform bonds over the next year? Are large companies going to better small ones? How about international companies? Will they outpace domestic ones? Nobody knows! I don't care who they are or what television show they are on – they don't know. They may have a decent idea, but they can't be 100% sure. For this very reason, we diversify. You should own positions that can move independently of other categories. We call them "non-correlated asset classes.” In other words, stuff that moves in different directions. Or, as one of my colleagues stated it, when one zigs, the other zags.

Now enters emotion. Your mix of positions is based on your risk tolerance or comfort level. If you get overly stressed and lose sleep when the market has a big drop, that will let you and your advisor know you might need to be a little more conservative.

This is NOT timing the market. This is designing a plan ahead of time that takes into account market fluctuations. Your plan will be determined by your risk profile.

Your risk profile is typically ascertained by answering a few questions. These allocations are put to the test through real-life experiences. It is important to answer the questions honestly. A good, independent advisor will also help determine what a prudent plan is based on your risk tolerance. No matter how conservative or aggressive you want to be, it is important to have different positions. If done correctly, proper diversification can increase your performance while, most importantly, reducing your risk.

If you enjoy doing all your own investing, I encourage you to put a solid, well-balanced plan together that incorporates multiple asset classes. If investing is somewhat intimidating, I encourage you to find a good, independent advisor who will listen to your concerns and spend the time to create a well-thought-out plan. Your future will thank you!